The Demand for Tax Haven Operations - Harvard Business School

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function for all multinational parents. In order to identify how a multinational’s overall foreign tax rate influences its use of tax havens, the analysis distinguishes larger, more populous, tax haven countries from smaller tax haven countries, where little employment and capital are located. Taxpayers have greater opportunity to locate taxable profits in larger havens, given the sizes of local economies. The evidence indicates that these larger tax havens serve a distinctive function, facilitating the reallocation of income from high-tax to low-tax locations, as parents in industries with high average foreign tax rates make greater use of such larger havens, conditional on using havens at all, and ownership of an affiliate in a large tax haven country is associated with reduced tax payments elsewhere in the same region. The size of a firm’s foreign operations and its use of tax havens are jointly determined, complicating the analysis of the extent to which the scale of activity in non-haven countries affects the demand for tax haven operations. Fortunately, it is possible to use rates of economic growth in foreign countries to predict differences between the subsequent foreign investment levels of American firms whose initial investments were located in different countries. Evidence from this instrumental variables analysis indicates that American firms are more likely to establish new tax haven operations if their non-haven investments are growing rapidly, which is consistent with the cross sectional evidence and the intuition that greater foreign investment increases the potential return to using tax havens. Section 2 of the paper reviews the taxation of foreign income and discusses evidence of the impact of taxation. Section 3 describes the available data on American direct investment abroad and characterizes tax haven activity of American multinational firms. Section 4 presents empirical evidence of the determinants of demand for tax haven operations, and in particular, the impact of high levels of foreign investment. Section 5 is the conclusion. 2. International taxation and the role of tax havens A substantial body of research considers the impact of taxation on investment and tax avoidance by multinational firms. 1 Tax policies are obviously capable of affecting the volume 1 See Gordon and Hines (2002) for a survey. For a fuller discussion of the tax rules facing U.S. multinational firms and the evidence on behavioral responses to international taxation of U.S. multinationals, see Hines (1997, 1999) and Desai, Foley and Hines (2003). 2
and location of foreign direct investment (FDI) since, all other considerations equal, higher tax rates reduce after-tax returns, thereby reducing incentives to commit investment funds. Previous studies identify the effects of taxes through time-series estimation of the responsiveness of FDI to annual variation in after-tax rates of return, and cross-sectional estimation that exploits the large differences in corporate tax rates around the world. A common finding of these studies, reviewed in Hines (1997, 1999), is that the estimated tax elasticity of investment is in the neighborhood of –0.6. Contractual arrangements between related parties located in countries with different tax rates offer numerous possibilities for sophisticated tax avoidance. It is widely suspected that firms select transfer prices used for within-firm transactions with the goal of reducing their total tax obligations. Multinational firms typically can benefit by reducing prices charged by affiliates in high-tax countries for items and services provided to affiliates in low-tax countries. OECD governments require firms to use transfer prices that would be paid by unrelated parties, but enforcement is difficult, particularly when pricing issues concern differentiated or proprietary items such as patent rights. Given the looseness of the resulting legal restrictions, it is entirely possible for firms to adjust transfer prices in a tax-sensitive fashion without violating any laws. Multinational firms can structure a variety of transactions – intrafirm debt, royalty payments, dividend repatriations, and intrafirm trade – in a manner that is conducive to tax avoidance. Studies of the responsiveness of firms to taxes on these margins examine reported profitabilities, tax liabilities, and specific measures of financial and merchandise trade in order to identify the effects of taxes. 2 This study’s emphasis on the role of haven activities is closest in spirit to Harris et al. (1993) and Hines and Rice (1994). Harris et al. (1993) report that the U.S. tax liabilities of American firms with tax haven affiliates are significantly lower than those of otherwise-similar American firms over the 1984-1988 period, which may be indirect evidence of tax-motivated 2 For evidence on intrafirm trade, see Clausing (2001, 2003) and Swenson (2001). For evidence on intrafirm debt, see Desai, Foley and Hines (2004a) and Grubert (1998). For evidence on royalties, see Grubert (1998) and Hines (1995). For evidence on dividend repatriations, see Desai, Foley and Hines (2001) and Hines and Hubbard (1990). See Grubert and Mutti (1991) and Hines and Rice (1994) for evidence on differences in reported profitability in response to tax rates. While these studies exclusively use data on U.S. multinationals, Bartelsman and Beetsma (2003) use country level data within the OECD to measure the prevalence of profit-shifting activities in a broader sample of countries. 3
Page 1 and 2: The Demand for Tax Haven Operations
Page 3: 1. Introduction Tax havens are low-
Page 7 and 8: 3. Data and descriptive statistics
Page 9 and 10: The analysis begins by identifying
Page 11 and 12: activity, rather than counts of aff
Page 13 and 14: 4.2. Tax havens and tax payments Ta
Page 15 and 16: distributions of foreign economic a
Page 17 and 18: significant (columns 5 and 6), the
Page 19 and 20: Grubert, Harry. (1998). “Taxes an
Page 21 and 22: Table 2 Descriptive Statistics Mean
Page 23 and 24: Dependent Variable: (1) (2) (3) (4)
Page 25 and 26: Dependent Variable: Table 6 First S
Page 27: Dependent Variable: (1) (2) (3) (4)

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